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Thursday, October 26, 2017

Mysteries of Modern Inflation

The theory of inflation that I learned long ago suggested that inflation should creep up when an economy is running near full employment, but will come back down during a recession. However, for almost two decades now, the rate of core inflation (that is, inflation not counting the volatile movements in oil and food prices) has stayed low and hasn't budged by very much. At one level, low and stable is clearly good news. But at another level, it raises a question of whether we really understand the causes of inflation. And if we don't understand it, how much confidence can we have that it will remain low and stable.

This mysterious behavior of inflation has been widely recognized, including by Fed chair Janet Yellen. David Miles, Ugo Panizza, Ricardo Reis and Ángel Ubide have now tackled the question in "
And Yet It Moves: Inflation and the Great Recession," published as Geneva Reports on the World Economy 19 by the International Center for Monetary and Banking Studies (associated with Geneva's Graduate Institute of International and Development Studies) and the Centre for Economic Policy Research. (October 2017). It's available through the VOX website (with free registration).

Near the start of the report, the authors offer a hypothetical question. If you were thinking about the path of inflation back in 2007 or so, and someone accurately described to you what was about to happen in the economy, what inflation rate would you have predicted? They write:

"[G]iven how volatile and often high inflation has been in the past, given that there was a deep recession and brief deflation episode in 2008-10, given that nominal interest rates were virtually constant (and the real interest rate was not), given that the monetary base increased five-fold, and given that central banks undertook unprecedented policies in a context of fiscal volatility, what would have been your guess about the stability and volatility of inflation from 2010 onwards?

"Simple versions of dominant economic theories, or superficial readings of economic history, would have all pointed to the conclusion that inflation should have at least been volatile, and possibly drifted up or down. Yet inflation was low and relatively stable. We did not observe deflation even in the presence of massive macroeconomic shocks and a sudden rise in unemployment, nor the much-feared inflation spiral that many expected after unprecedented easing in monetary policy. It is remarkable that the volatility of inflation remained so low, in spite of new policies and many shocks. ...

"Overall, inflation has not diverged much from its 2% target and, if anything, has been below and struggled to return to 2%. One reaction to these facts is complacency: inflation is a solved problem that we do not need to worry about. This report rejects this view. We will suggest that the stability of inflation poses puzzles for our existing theories, suggesting that inflation control is far from a solved problem. Complacency, in our view, can quickly lead to inflation getting out of hand, in any direction, in the coming years. ...

"The young, or those with short memories, could be forgiven for looking condescendingly at their older friends who speak of inflation as a major economic problem. But, like Galileo Galilei told his contemporaries who thought the Earth was immovable, “Eppur si muove” (“and yet it moves”). Since most societies regard stable inflation as a goal, it is tempting to describe this solid anchoring of inflation as a great achievement of monetary policy. But what if it was just luck? Will the great anchoring soon be followed by a great bout of inflation, or by a descent into deflation, just as the Great Moderation was followed by the Great Recession?"

Notice that little phrase "in any direction" near the end oft the quotation, which emphasizes that the problem with inflation can either been that it jumps too high, or that it falls too low. The authors argue in some detail that basic views about causes of inflation--for example, a sharp economic slowdown should lead to a substantial fall in inflation, or a large rise in the money supply should lead to a substantial rise in inflation--haven't held up well in recent years. Instead, they suggest that understanding inflation in recent years requires looking at "the role of commodity prices, the anchoring of inflation expectations, shifts in the Phillips curve, changes in mark-ups of prices over costs, the change in central bank liabilities from currency to reserves, and the impact of policy announcements ..."

What are some of the issues and insights that arise from this alternative view? Here are some of the questions they raise and a sense of the answers they offer (citations omitted throughout):

"Would a higher inflation target be warranted?"

"In the end, whether a higher inflation target will be needed or not will depend, to some extent, on luck. Will productivity growth rebound, and will neutral interest rates increase, creating more room to ease policy? Will future shocks resemble those of the Great Moderation, or will they be Lehman sized? Because of these uncertainties, one strategy would be to establish a process of periodic revisions, say every five or ten years, to the inflation target (as it is done in Canada, for example). This would force a regular evaluation of the cost and benefits of existing inflation targets, in light of the accumulated new evidence. ... Even in the last decade, there is growing academic work showing that even from a cost of living perspective, biases associated with new goods and substitution may have got worse, so associating an unchanged numerical target with price stability at all times is not right. There is no reason why 2% is the right answer – for all periods and for all economies – to the question: “What should the target rate of inflation be?”"

"Should central banks have large balance sheets?"

"Central bank balance sheets look very different now from what they were in 2007. They have grown enormously – a fivefold increase relative to GDP for the Fed and the Bank of England, and not much less for the ECB. The Japanese central bank balance sheet has been on an upwards trajectory for much longer. Moreover, central bank balance sheets are likely to remain very large for a long period. With the system of payment of interest on excess reserves, central banks can operate monetary policy with any balance sheet size. (Indeed, the concept of ‘excess’ reserves becomes redundant). The scary crisis episode of the failure of the interbank market has led central bankers to conclude that, for financial stability reasons, a world with far higher reserves than used to be thought adequate may be optimal. To the extent that the current high levels reflect a desire by commercial banks to hold more reserves (and rely less on the interbank market), it looks like something that central banks should allow as part of their role in creating the infrastructure for efficient financial intermediation. A large balance sheet gives the central bank the tools to target financial stability with close to zero effect on inflation."

"What is the role of forward guidance?"

"Guidance on how [monetary] policy will be set, what it is trying to achieve, how trade-offs between risks and trade-offs between objectives are balanced, and on the outlook for the drivers of inflation are all valuable. They become particularly useful when inflation is away from its target, and when current policy may be a long way from what has been normal and may also be constrained. That is the world we have been in since the financial crisis

"The case for forward guidance which constrains future discretion (Odyssean guidance) is less powerful. One such form of limited discretion is to commit to a particular policy rule. But no policy rule could be comprehensive enough to reflect the appropriate response to news (on data and on the changing structure of the economy) and also be useful and understandable to outsiders. ...

"All in all, central banks are right to maintain some discretion and not to make commitments to follow rules that are too specific. The world is too complex and unexpected events happen too often to make that desirable. But the more discretion central banks have, the more guidance they need to give on their strategy, not less."

"Has monetary policy been too focused on inflation?"

"Looking at the period since the financial crisis, it seems that inflation targeting has been sufficiently flexibly applied by most central banks that it has not in fact been a straitjacket. Furthermore, while inflation has been persistently under the 2% target in most advanced economies, it is not at all clear that it has been in a danger zone where deflation and debt spirals are just around the corner. ...

"Clearly in very many economies, aggregate performance since the 2007-2008 financial crisis has been poor (in the UK, for example, GDP is now around 15% below a continuation of the trend the UK seemed to be on before 2008). Would that have been much better had inflation been close to 2% rather than averaging closer to 1%? And would the problem have been much reduced had central banks not pursued (flexible) inflation targeting pre-crisis? One (perhaps simplistic) view is that the huge policy error pre-crisis was that regulators didn't seem to worry about banks with a leverage of 50 times, and that when you have banks with 98% debt and 2% equity, you are sitting on a mountain of dynamite smoking a cigar. In 2007, the dynamite exploded in the US. In 2008, it exploded in the UK and a bit later it exploded across the rest of Europe. The explosions might have everything to do with too high leverage – a view forcefully put by Admati and Hellwig (2013) and many others – and little to do with inflation or inflation targeting. ...

"Our conclusion is that flexible inflation targeting remains a sensible strategy. It clearly should not preclude expansionary (contractionary) policy when inflation is temporarily above (below) target."

"What is the role of fiscal policy in managing inflation?

"At a minimum level, if central banks are to be held responsible for inflation outcomes, fiscal policy must be chosen so that plans for fiscal surpluses are consistent with paying down the existing debt. This prevents agents from expecting inflation to be necessary in order to pay for the debt. Moreover, for the central bank to remain independent and use its tools , the fiscal authorities must back the central bank in the sense of not demanding an exogenous stream of positive dividends from it, which would force it to use inflation to generate seignorage revenues. Third, even if this stops well short of the full extent of policy cooperation, fiscal deficits that stimulate real activity can help to push up inflation in situations where monetary policy faces limits to its tools."